Financial Accounting
Managerial accountants adopt the discourse of financial accounting to determine performance. They use net worth from transactions and profitability over a period of time. Net worth is reported on the balance sheet (statement of financial position) and profitability on the income (profit and loss) statement. Managerial accountants express this as the distinction between product costs and period costs (also known as period expenses). A period cost cannot be capitalized into the prepaid expenses, inventory or fixed asset accounts but is immediately treated as an expense. Discourse between the managerial accountant and non-accounting managers therefore centers on what are advantageous classifications. To inflate product costs, classification will favor those direct costs (e.g., direct labor and direct materials) and indirect costs (e.g., manufacturing overhead), which relate to the acquisition and production of products. To inflate period costs the operating expenses of selling costs and administrative costs will be used. There are four consequences for discourse. First the definitions in the chart of accounts provided by the managerial accountant are brief so they need to explain their financial implications of classifying operating costs as manufacturing costs or non- manufacturing costs to non-accounting managers. For example, the managerial accountant will frustrate some attempts to loosen definitions by pointing out that product costs can no longer be counted once the product leaves the production line (e.g., distribution costs). Second practice of deliberate or accidental misclassifications between product costs and period costs and within them will misstate product costs and period costs. As a result, the managerial accountant will recheck this financial information before using it. For example, misstatement of indirect costs can affect the apparent attractiveness of outsourcing. Third the attempt to shift the some of the expenses of creating new products or improving existing products to existing product costs. Since these are not part of the production of current products, the managerial accountant will treat them as operating expenses either i n variable operating expenses or fixed operating expenses. Finally, every cost allocation of indirect costs among products method is arbitrary. As a result, the managerial accountant will cost a range of options to anticipate the convincing arguments that non-accounting managers are likely to proffer for their preferred allocation method. For example, apart from fixed and proportional allocations, several indirect cost rate calculations can be systematically determined by dividing an indirect cost by a cost object (e.g., sales revenue or area occupied). These consequences have even greater potential impact on the financial position of the organization where customers have the choice of customizing their order by selecting from many products or services. Of course, deliberately misclassifying manufacturing costs as non-manufacturing costs to minimize income tax is illegal.
However, recent examples from the banking and motor vehicle industry suggest the use of non- allowable classifications was not a deterrent.
Table 3-3 shows the operationalization of product costs and period costs with reference to manufacturing a product using the two different costing methods (absorption or variable costing).
Finished goods when placed in inventory, may be accounted for by either allowing all costs of production (absorption costing also known as full costing or traditional costing), or only considering
the costs of production that vary with output (variable costing also known as direct costing or marginal costing). Table 3-3 shows the difference between the two methods is in the treatment of fixed manufacturing overhead costs.
Table 3-3 Absorption versus variable costing for product and period costs.
Costing Method Cost Classification
Absorption
(Full) Variable Cost Assignment Cost Behavior
Product cost Product cost
Direct labor Variable manufacturing
overhead
Period cost Period cost
Fixed manufacturing overhead Variable selling and administrative
expenses
Fixed selling and administrative expenses
The managerial accountant uses multiple classifications to perform multiple calculations. Both costing methods are usually calculated because variable costing is used by internal managers for decision-making purposes, while absorption costing provides information used by external parties (primarily creditors, but also auditors and government agencies) as well as internal managers. Each has unique benefits and limitations. Absorption costing provides a more accurate accounting of net profit, particularly when sales occur in a period after production. Variable costing provides a better understanding of the effect of fixed costs on net profit because total fixed cost for the period is shown on the income statement as well as net operating income, which may approximate the cash flow. Since variable costing does not assign fixed cost to units of products, the production costs cannot be truly matched with revenues. That is, there are distinctions but also relationships between product and period costs. Figure 3–2 summarizes both the distinction and the connection in the staged transfer of costs between the inventory and cost of goods sold accounts based on product cost or period cost.
Product costs (also known as production costs) are expenses that an organization incurs in acquiring raw materials and manufacturing a product. Product costs are initially treated as inventory so they do not appear on income statement until the product is sold. Once the product is sold, these costs are transferred to cost of goods sold account. All other expenses an organization incurs that are not product costs are period costs. Period costs remain separate from product costs. So, an organization does not need to wait for the sale of products to recognize them as expense. They arise during a specific accounting period. According to Generally Accepted Accounting Principles (GAAP), all marketing costs, selling costs and administration costs are treated as period costs. The managerial accountant distinguishes between absorption costs and variable costs to improve the product cost
accuracy, so that non-accounting managers can set prices. Simon, (2015) identifies the central place of price in determining profit by tracing its antecedents (innovation, value, customer awareness and understanding, and the use of alternatives to shift consumption to higher-priced products. Therefore, the managerial accountant will be mindful that Simon (2015) considers that very few companies will achieve long-term success with a low-price strategy.
Despite their internal focus, the managerial accountant is aware that their calculations, analyses and recommendations may be used in financial accounting. This is apparent from discourse that is likely to take the form of narrative describing the circumstances behind making the calculation which place the figures at its center. Since a narrative is also an account, the figures do not stand by themselves. They are likely to be framed to bolster success and pre-empt unfavorable interpretations.
The managerial accountant may be the instigator of the discourse or respond to it. Their argument will depend upon the understanding shown by non-accounting managers of both financial statements and their commitment to operational imperatives. This suggests that a large proportion of the managerial accountant’s time should be devoted to discourse to validate the information they use for calculations, analyses and recommendations. Another task in their discourse is uncovering confusion, ambiguity and
Figure 3-2 Distinction and the connection in the staged transfer of costs between the inventory and cost of goods sold accounts based on product cost or period cost.
well-meaning misjudgments used by non-accounting managers making accounting-related decisions.
The related issue of performance and control is discussed in Chapter 8, which is introducing the managerial accountant’s compass. In some instances, reframing discourse around cost management will highlight misconceptions about financial information and ensure non-accounting managers take decisions informed by insights from the managerial accountant.